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budgeted unit contribution and resourcerequirements of each of these products areshown in table 1. The kettles are made froman advanced heat-resistant material that givesthe firm a competitive advantage. An e-mailfrom the purchasing manager has informed usthat, because of a problem with the supplier,it should be assumed that the years supply ofthis special material is limited to 28,000kg.We can also assume that, since Scarspreyoperates just-in-time production methods,opening and closing inventory levels are zero.The sales director has already accepted anorder for 1,000 Deluxe kettles that, if notfulfilled, would incur a financial penalty of$2,000. This order is included in the Deluxesmaximum market demand figure.

My previous article on decision-makingconcepts (November/December 2009)showed that a decision should be taken withreference to the relevant costs and benefitsrelating directly to it. In particular, it showedthat the contribution per unit of scarceresource can be used to prioritise productionin cases where there are insufficient quantitiesof one material.

Lets now extend the analysis to cover asituation where there is a minimum demandconstraint owing to the existence of acontract containing a penalty clause for anyfailure to fulfil its obligations. Suppose thatthe Scarsprey Company manufacturesthree types of kettle: Basic, Deluxe andSuper. The maximum market demand,

We need to work out whether Scarspreyshould go ahead and satisfy the contract athen prioritise production in the normal wayor whether it should consider breaching thecontract and incurring the penalty.

First, lets look at the situation that wouldoccur if the firm were to fulfil the contract bconsidering once again the issue ofprioritising production. From table 1 we cansee that Basic kettles would have acontribution of $8.00 2.00kg = $4.00 perkg of special material; Deluxe kettles wouldhave a contribution of $3.00 per kg; andSuper kettles would have a contribution of$3.50 per kg. This means that the order ofproduction priority would be Basic first,Super second and Deluxe third.

Of course, there is a more pressing prioif we are determined to satisfy the contractthe company must make the 1,000 Deluxekettles before using the rest of the specialmaterial to make Basic kettles, then Superkettles and then if theres any material left

more Deluxe kettles (see table 2).The contribution resulting from thisproduction plan is as follows:n 4,500 Basic units x $8.00 = $36,000.n 1,000 Deluxe units x $15.00 = $15,000.

n 1,750 Super units x $28.00 = $49,000.This makes a total contribution of $100,000

Now we can consider the impact ofbreaking the contract and whether doing sois financially worthwhile. To do this, we simpignore the requirement for a minimum of1,000 Deluxe kettles and, using fundamentprinciples, reformulate the production plan in table 3. The contribution resulting from th

revised production plan is as follows:n 4,500 Basic units x $8.00 = $36,000.

n 2,375 Super units x $28.00 = $66,500.This makes a total contribution of $102,500 ie, an increase of $2,500 on the first plan

With practice, you should be able to takeshorter, more efficient route to the newsituation: by not making 1,000 Deluxe kettlewe release 1,000 x 5kg = 5,000kg of materiThis was yielding a contribution of 1,000 x$15.00 = $15,000, which is now sacrificed t

fnancial management6

Performance managementIan Janes shows how to solve a problem eaturing a minimum demandconstraint resulting rom the existence o a contract with a penalty clause

1 Ky budi d Sspys h ks kl

Basic Deluxe Super

Maximum demand (units per year) 4,500 2,000 4,000

Contribution per kettle ($) 8.00 15.00 28.00

Special material used per kettle (kg) 2.00 5.00 8.00

2 Pdui pl i h is b hud

Basic Deluxe Super Total

Minimum units to satisfy contract 1,000

Special material required for contract 5,000kg 5,000kg

Units to satisfy max demand (Basic) 4,500 0 1,750or use remaining resources (Super)

Material to be used in production 9,000kg 0 14,000kg 23,000kgof Basic and Super kettles

Material available and used 28,000kg

Total number of units produced 4,500 1,000 1,750

3 Pdui pl i h is b bk

Basic Deluxe Super Total

Units to satisfy max demand (Basic) 4,500 0 2,375or use remaining resources (Super)

Material to be used in production 9,000kg 0 19,000kg 28,000kgof Basic and Super kettles

Material available and used 28,000kg

Total number of units produced 4,500 0 2,375

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make way for alternativeproduction ($15,000could be described asthe opportunity cost).Instead, we can use5,000kg of material to make5,000kg 8kg per unit =625 more Super kettles.These kettles will yieldcontribution of 625 x $28.00 =$17,500, which represents the same increaseof $2,500 we calculated before.

Alternatively, the rate at which contributionwas earned on Deluxe kettles was $3 per kg,but is $3.50 per kg on the Super kettles. Thescarce 5,000kg of material is, therefore, nowearning $0.50 more per kg, representing anincrease in contribution of $2,500.

Whichever way you look at it, the revisedproduction plan increases contribution by$2,500, which exceeds the $2,000 financialpenalty for breaking the contract.

In simple financial terms, there is a net gain

of $500 for failing to honour the contract andredirecting scarce resources. Indeed, as longas the penalty is less than $2,500, it would befinancially worthwhile for Scarsprey to breachthe contract. But this isnt the completepicture, since a range of non-financial factorsthat have financial implications need to beconsidered if a good decision is to be made.Key issues to consider in this case include:n Will the customer, whose contract we

would have reneged on, ever come backto us for more business?

n Should the news of our failure to fulfil acontract become common knowledge in

the trade, then the damage to Scarspreysreputation and the consequent loss ofgoodwill could amount to far more, interms of lost sales and contribution, thanthe net gain of $500.

n Will the decision to make only two types ofkettle instead of three have a harmfuleffect on customer loyalty and salesdemand? This could happen if thecustomers are retailers who wish to offeras wide a range of products as possible.

n What are the long-term effectsof vacating the market forDeluxe kettles? Its likely thatScarspreys rivals would movequickly to fill the gap.

Clearly, Scarsprey will wantto get to the root of theproblem: the dearth of special

material. So, working from therevised plan, if the company is able

to find extra material from elsewhere, thenclearly it should do so, as long as thepremium* for each kilogram (the cost overand above that already being paid) is lessthan $3.50. Since the contribution perkilogram of material used in producing theSuper kettle is $3.50, this would make itworthwhile to obtain material from anothersupplier. This figure is referred to as theshadow (or dual) price of a kilogram ofmaterial, but will stay at $3.50 per kg only aslong as the material is being used to makeSuper kettles ie, up to the maximum

demand of 4,000 units. In this case it wouldbe another 1,625 units x 8kg = 13,000kg.Once the maximum demand for Super

kettles is satisfied, any further special materialthat can be found would in theory be used tomake Deluxe kettles, when the maximumpremium to be paid would then switch to $3per kg. But by now were looking at findingabout 50 per cent more material than we firstthought was available, so this seems unlikely as indeed is making enough of these unitsto avoid the financial penalty.

Decision-making problems in P2 involve adegree of complexity that you may not have

seen in your earlier studies. In this case, weconsidered whether it was financiallyworthwhile to breach a contract in order toincrease contribution levels. Such a choiceshould come with a warning, because non-financial issues such as damage to goodwill,a loss of reputation and a reduction in futuresales and contribution must all be considered.

Ian Janes is CIMA course leader atNewport Business School.

* Note that we refer to the premium for each kilogra

since the normal cost of a kilogram of material, whic

we assume remains the same, is already factored in

the contribution per unit.

PAPER P2

Try the following question to test yourunderstanding. The solution will appearin CIMAs student e-magazine, Velocity(www.cimaglobal.com/velocity).

Assume that one year has passedsince the situation described in the maintext arose for Scarsprey, but that therestriction on the supply of specialistmaterial remains ie, only 28,000kg of itis available for the coming year.

All other information is as previouslystated, except the following:n Scarsprey has rebranded the Super

kettle as a premium product and hasincreased the selling price such that ityields a contribution of $34 per unit.But this means that the maximumdemand for Super kettles has fallen to2,000 units this year.

n The sales director has taken an order

for 800 Deluxe kettles that, if notsupplied in full, would incur the samepenalty as before ie, $2,000. Thisquantity is included in the maximummarket demand figure of 2,000 units.You can continue to assume that,

since Scarsprey operates just-in-timeproduction methods, the opening andclosing inventory levels are zero.

You are required to:1 Formulate the companys optimum

production plan for the year, includingan evaluation of whether its financiallyworthwhile for the company to breach

the contract.2 State the shadow price of a kilogram

of the specialist material and calculatethe quantity (in kilograms) of materialto which this price applies.

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